China's currency devaluation is just getting started

The U.S. dollar (USD) has gained over 35% against major
currencies since 2011.

China’s government has pegged its currency, the yuan (renminbi)
to the USD for many years. Until mid-2005, the yuan was pegged at
about 8.3 to the dollar. After numerous complaints that the yuan
was being kept artificially low to boost Chinese exports to the
U.S., the Chinese monetary authorities let the yuan appreciate
from 8.3 to about 6.8 to the dollar in 2008.

This peg held steady until mid-2010, at which point the yuan
slowly strengthened to 6 in early 2014. From that high point, the
yuan has depreciated moderately to around 6.5 to the USD.

The
Daily Reckoning

Interestingly, this is about the same level the yuan reached in
2011, when the USD struck its multiyear low. Since 2011, the USD
has gained (depending on which index or weighting you choose)
between 25% and 35%. I think the chart above (trade-weighted USD
against major currencies) is more accurate than the conventional
DXY index.

Due to the USD peg, the yuan has appreciated in lockstep with the
U.S. dollar against other currencies. On the face of it, the yuan
would need to devalue by 35% just to return to its
pre-USD-strength level in 2011. This would imply an eventual
return to the yuan’s old peg around 8.3–or perhaps as high as
8.7.

The dynamic is clear. A splurge of new lending can help to dilute
existing bad loans, but only at a cost. This is a game that can’t
continue forever, particularly if credit is being foisted on to
an already over-leveraged and slowing economy. At some point, the
music will stop and there will have to be a reckoning. The longer
China postpones that, the harder it will be.

Mark also submitted the following commentary:

It seems the best way to assess the likely effects and outcomes
is to look at what the Chinese government can control, and at
what it can’t control. And we should observe at the start that
the yuan is not a global reserve currency.

1. Beijing can control the amount of yuan in existence. It can
therefore easily pay off all these bad internal debts, at least
in a strict book keeping sense. And it can also recapitalize its
bankrupt banks to any degree necessary, at least in yuan. The
process of doing so involves assigning winners and losers. The
latter group will comprise anyone earning a subsistence working
wage in yuan and anyone whose assets primarily consist of savings
in yuan.

2. Undertaking #1 will lead to a large increase in the amount of
yuan in existence. Here Beijing will be acutely sensitive to any
increase in food prices since this can swiftly lead to mass food
riots and the concomitant rapid and bloody end of the regime.
Therefore food prices have to be insulated somehow from this huge
internal devaluation.

3. Beijing cannot permanently control the yuan-dollar exchange
rate or any other FOREX rate involving yuan. It can do so in the
short term but only to the limit of its usable foreign exchange
reserves. This total is minus the FOREX working capital China
needs to pay for imported raw materials and fuels. And also food:
China’s Growing Demand for Agricultural Imports (USDA).

Damaged
100 yuan banknotes.Reuters/Stringer

It appears that one certain outcome will be a huge depreciation
in the value of yuan. Bailout of the bad bank debt is reason #1
to print yuan. The decline of yuan will lead to lower prices and
a temporary relief of U.S.-based automation pressure on export
market share. This begins to become a Reason #2.

How this will be received outside China is the immediate
question. Probably not too favorably.

One way to paper over impaired loans is to issue a flood of new
credit: this dilutes the problem and enables defaulted loans to
be “paid down” with new loans that are doomed to default once the
ink is dry: China Created A Record Half A Trillion Dollars Of
Debt In January (Zero Hedge)

Here’s the larger context of China’s debt/currency implosion.
From roughly 1989 to 2014 — 25 years — the “sure bet” in the
global economy was to invest in China by moving production to
China.

This flood of capital into China only gained momentum as the yuan
appreciated in value against the USD once Chinese authorities
loosened the peg from 8.3 to 6.6 and then all the way down to 6
to the dollar.

Every dollar transferred to China and converted to yuan gained as
much as 25% over the years of yuan appreciation. Those hefty
returns on cash sitting in yuan sparked a veritable tsunami of
capital into China.

Now that the tide of capital has reversed, nobody wants yuan: not
foreign firms, not FX punters and not the Chinese holding massive
quantities of depreciating yuan.

PBOC
headquarters in Beijing.Thomson
Reuters

This is why “housewives” from China are buying homes in Vancouver
B.C. for $3 million. That $3 million could fall to $2 million as
the yuan devalues to the old peg around 8.3 to the USD.

Who’s left who believes the easy money is to be made in China?
Nobody. Anyone seeking high quality overseas production is moving
factories to the U.S. for its appreciating dollar and cheap
energy, or to Vietnam or other locales with low labor costs and
depreciated currencies.

For years, China bulls insisted China could crush the U.S. simply
by selling a chunk of its $4 trillion foreign exchange reserves
hoard of U.S. Treasuries. Now that China has dumped over $700
billion of its reserves in a matter of months, this assertion has
been revealed as false: the demand for USD is strong enough to
absorb all of China’s selling and still push the USD higher.

The stark truth is nobody wants yuan any more. Why buy something
that is sure to lose value? the only question is how much value?
The basic facts suggest a 30% loss and a return to the old peg of
8.3 is baked in.

But that doesn’t mean the devaluation of the yuan has to stop at
8.3: just as the dollar’s recent strength is simply Stage One of
a multi-stage liftoff, the yuan’s devaluation to 8 to the USD is
only the first stage of a multi-year devaluation.